This week, following the FOMC meeting, the Federal Reserve left the federal funds rate unchanged – at a range of 5.25 to 5.5 percent. No surprise there.
The real dirt, however, was buried in the implementation note. That’s where the Fed revealed that starting June 1, it will taper its monthly balance sheet reduction of U.S. Treasuries from $60 billion to $25 billion. In other words, $105 billion less Treasuries will need to be issued in Q3.
The Fed, in essence, is trying to put a lid on rising interest rates. Perhaps this buys the Fed, and the overextended financial system, a little time in an election year. But with persistently high consumer price inflation and a balance sheet that’s still over $7.4 trillion, this simmering pot must to boil over.
For there are factors at play which are much greater than Fed monetary policy. If you understand the mechanics of what’s going on, you’ll be well ahead of 99 percent of your peers – and even many of the so-called professionals. Where to begin?
Yesterday [Thursday], and even with the Fed’s taper announcement, the yield on the 10-Year Treasury note closed at 4.58 percent. Not far from the 16-year high of nearly 5 percent reached last October. After backing off for several months, yields are again on the rise.
And as yields continue to rise, and credit markets continue to tighten, this one thing will change everything. In fact, it already is.
The world we’ve entered – a world of rising interest rates – is an unfamiliar place. Americans haven’t experienced it in over four decades. But, nonetheless, it is part of the long term, secular movement of the credit cycle. To understand what’s going on, all you need to do is look to the past and key in on several critical inflection points.
Interest Rates and Asset Prices
Something momentous happened in September of 1981. The rising part of the interest rate cycle peaked out. At the time, interest rates had been going up for over 40 years. People likely thought they would keep going up forever.
But then something unexpected happened. Interest rates didn’t go up. They went down. And not only did they go down. They went down for the next 39 years. In doing so, the seeds of a mega-disaster were multiplied and scattered across the land.
The relationship between interest rates and asset prices is generally straightforward. Tight credit generally results in lower asset prices. Loose credit generally results in higher asset prices.
When credit is cheap and plentiful, individuals and businesses increase their borrowing to buy things they otherwise couldn’t afford. For example, individuals, with massive jumbo loans, bid up the price of houses. Businesses, flush with a seemingly endless supply of cheap credit, borrow money and use it to buy back shares of their stock – inflating its price and the value of executive stock options.
When credit is tight, the opposite happens. Borrowing is reserved for activities that promise a high rate of return; one that exceeds the high rate of interest. This has the effect of deflating the price of financial assets.
Credit was expensive in 1981, while stocks, bonds, and real estate were cheap. If you can believe it, the interest on a 30-year fixed rate mortgage reached a high of 18.45 percent in 1981. That year, the median sales price for a U.S. house was about $70,000.
In contrast, the interest rate on a 30-year fixed rate mortgage bottomed in December 2020 at 2.68 percent, and the median price of a U.S. house inflated through late-2022 to a peak of $479,500. Along the Country’s east and west coasts, prices spiked up much higher.
Similarly, the Dow Jones Industrial Average (DJIA) was roughly 900 points in 1981. Today, the DJIA is about 38,225 points. That comes to over a 4,147 percent increase. Yet over this same period, gross domestic product has only increased by roughly 805 percent.
Trend Reversal
The near 40-year run of cheaper and cheaper credit was the primary contributor to ballooning stock and real estate prices. Asset prices and other financialized costs, like college tuition and cars, were also grossly distorted and deformed by four decades of cheaper and cheaper credit.
What’s more, the disparity between high asset prices and low borrowing costs has positioned the world for an epic mega-disaster. As interest rates rise, asset prices must fall. The median sales price for a U.S. house as of the end of last year has dropped to $417,700 – down over 12 percent from the peak.
Without question, the Federal Reserve has an extreme and heavy-handed influence over credit markets. But the Fed is not the master of it. The fact is Fed credit market intervention plays second fiddle to the overall long trend rise and fall of the interest rate cycle.
From a historical perspective, today’s 10-Year Treasury note yield of 4.58 percent is slightly above its long-term average of 4.49 percent. But if you consider just the last three years, it’s extraordinarily high.
Specifically, the yield on the 10-Year Treasury note bottomed out at just 0.62 percent in July 2020. At 4.58 percent today, the yield has increased dramatically. In total, over the last 46 months, the yield on the 10-Year Treasury note has increased over 638 percent.
The last time the interest rate cycle bottomed out was in December 1940. The low inflection point for the 10-Year Treasury note at that time was a yield of 1.95 percent. After that, interest rates generally rose for the next 41 years.
What hardly a living soul remembers is that the Fed’s adjustments to the federal funds rate have drastically different effects during the rising part of the interest rate cycle than during the falling part of the interest rate cycle.
Policies of Disaster
Between 1987 – with the advent of the Greenspan put – and 2020, each time the economy went soft, the Fed cut interest rates to stimulate demand. In this disinflationary environment, the credit market limited the negative consequences of the Fed’s actions.
Certainly, asset prices increased, and incomes stagnated. But consumer prices did not completely jump off the charts. The Fed took this to mean that it had tamed the business cycle. This couldn’t be further from the truth.
During the rising part of the interest rate cycle, as demonstrated in the 1970s, after the U.S. defaulted on the Bretton Woods Agreement, Fed interest rate policy failed repeatedly.
Over that decade, and much like today, Fed policy makers were politically incapable of staying out in front of rising interest rates. Their efforts to hold the federal funds rate artificially low, to boost the economy, didn’t have the desired effect.
In this scenario, and as we’ve experienced since July 2020, monetary inflation coupled with deficit spending produced consumer price inflation. Fed policies during the rising part of the interest rate cycle are policies of disaster.
In July 2020, roughly 39 years after they last peaked, interest rates finally bottomed out. Yields are now rising again – and the Fed can’t stop it. In truth, interest rates may rise for the next three decades.
This means the price of credit will increasingly become more and more expensive into the mid-21st century. Hence, the world of perpetually falling interest rates – the world we’ve known since the early days of the Reagan administration, where you can refinance your debt every several years to reduce your debt burden – is over.
Alas, all this is happening at a time of record household, business, and government debt. It will take some practice for households, businesses, and investors to learn how to safely navigate the world of rising interest rates. Those who are overburdened with debt will undoubtedly go bankrupt.
The implication for government budgets – and interest on the debt – will be unbearable. And as a result, the dollar will be debased in earnest.
[Editor’s note: It really is amazing how just a few simple contrary decisions can lead to life-changing wealth. And right now, at this very moment, I’m preparing to make a contrary decision once again. >> And I’d like to show you how can too.]
Sincerely,
MN Gordon
for Economic Prism
